Lessons from the turmoil

The history of financial regulation shows such regulation is rooted in crisis. Significant regulatory change usually takes place in response to the perceived inability of the previous regime to anticipate and prevent a crisis. This is not in and of itself a negative attribute. Any attempt to envisage every possible scenario and build in regulatory safeguards in anticipation can completely stifle innovation. However, it is critical that the right lessons are learned from every crisis. The true test of a regulatory system lies in its ability to avoid the same crisis a second time around.

As the global financial system deals with the fallout of the sub-prime crisis in the US, it is perhaps time to start thinking of the regulatory lacunae that both caused and spread the problem and what needs to be done to close the gaps. Here are three possible lessons from the unfolding of the sub-prime crisis. First, the measurement of risk needs to be significantly improved. As securities become more and more complex and distanced from the original transaction the difficulty in measuring their inherent risk increases. Under these circumstances, for banks and other financial institutions to rely almost exclusively on external and model-based internal ratings to decide on both exposure levels and provisions against losses is apparently inadequate. For derivative securities, there may be a case to be made for a second level of scrutiny, for example, what exactly the original transaction put out money for. The boards and other supervisory mechanisms of these institutions need to lay out explicit criteria for investments in derivative instruments, based on both ratings and this kind of deeper examination. This will certainly increase the costs of carrying out due diligence, but could bring stability to the system by both restricting demand for highly risky new products and drawing boundaries within which genuine financial innovation can take place.

Second, sometimes what is intended to prevent a crisis may actually aggravate it. There is a view that, in the recent bouts of volatility in global stock markets, strict enforcement of margin requirements by exchanges resulted in many players losing access to the market, thus thinning it out and snowballing the decline. While margin requirements are a fundamental tool for maintaining order in markets, some flexibility in enforcing them in critical situations may help to stabilise markets, outweighing the benefits of risk mitigation from rigid enforcement. Of course, such circumstances call for extreme discretion and highly effective co-ordination between banking and market regulators.

Third, perhaps it is time to move away from very micro-level regulatory approaches, which provide explicit disclosure and prudential norms for various asset classes, to ones that work at a more macro level through principles and guidelines. While many countries claim to have done this, there is perhaps enough residual micro-management in these systems, which then incentivise players to seek out the niches and loopholes, which eventually get them into trouble. Ultimately, the "crisis" approach to regulation admits that regulators will always be one step behind market participants. The best they can do is install enough shock absorbers into the system to deal with the impact of a breakdown. Letting go might be the last thing that regulators would consider in these turbulent times, but it has to find a place in the script that is being written for the future.